Sunday, October 25, 2009

Is Gold Disappearing from the Streets and Going Back to the Vaults?

25 October 2009

As I have recently posted, I have been visiting the Seeking Alpha site in order to find up-to-date investment market news and more intelligent than average reader commentary.

A couple of interesting ideas came up while I was reading Andrew Butter's article, "Roubini Hates Gold: Is He Wrong Again?"

Briefly, Mr. Butter reprises Nouriel Roubini's recent arguments against gold's currently rising price. Mr Roubini stated (wrongly in my view):

"I don’t believe in gold. Gold can go up for only two reasons. [One is] inflation, and we are in a world where there are massive amounts of deflation because of a glut of capacity, and demand is weak, and there’s slack in the labor markets with unemployment peeking above 10 percent in all the advanced economies. So there’s no inflation, and there’s not going to be for the time being.

"The only other case in which gold can go higher with deflation is if you have Armageddon, if you have another depression. But we’ve avoided that tail risk as well. So all the gold bugs who say gold is going to go to $1,500, $2,000, they’re just speaking nonsense. Without inflation, or without a depression, there’s nowhere for gold to go. Yeah, it can go above $1,000, but it can’t move up 20-30 percent unless we end up in a world of inflation or another depression. I don’t see either of those being likely for the time being. Maybe three or four years from now, yes. But not anytime soon."

Mr. Butter was also, in my opinion, off-base in his critique, stating the following:

"I don’t exactly agree with Roubini, although I agree with him on deflation, just I don’t buy the idea that it’s inflation (in particular) that drives gold prices; but I agree with his conclusion, and it’s good to know that there is at least one other person in the world who doesn’t buy the idea of gold breaking out and heading towards heaven (I was getting pretty lonely actually).

"I think that gold is a bubble fuelled by excess liquidity and wonky valuations that you tend to get at the top of every bubble (remember the weird explanations of how to value a stock at the top of that bubble).

"The latest I heard is that it’s all about lack of confidence in government. Well, the peak of that 'lack of confidence' was February/March 2009; and what happened to gold then? It dropped.

"The best predictor of the gold price since 1971 was the price of oil (74% R-Squared on an annual basis), and by that measure at $75 a barrel the price of gold should be $750, which means now it’s a bubble, which means if it comes down and oil doesn’t go up, then it could drop to $600."

While I disagree with both Mr. Roubini's and Mr. Butter's primary theses, I was struck by the number of insightful comments by readers in response to Mr. Butter's article. Many commenters were not taken in by the above (spurious) arguments. And one post in particular set my thoughts meandering down a new path.

In this comment, "manya05" (I'm not sure why people don't use their actual names in making internet posts, but what do I know of young folks' behaviour these days?) stated:

"Roubini gives two scenarios in which gold can move up and discounts them both, and maybe he is right. But he forgot a third possible reason giving force to a move up in gold. Most central banks around the world (big and small) are trying to figure out how to 'de-dollarize' their reserves. They are diversifying as best they can, I am sure they are converting dollars to other currencies, but ultimately they realize that holding reserves in the currency of another government is not a wise idea...whatever the currency. So, what are they going to keep as reserves? Amphorae of olive oil and bags of grain like in the old days? I don't think so, if gold worked as a good store of value for 1000s of years, for the short term, it is the obvious route for central banks to take. So I think Roubini is wrong, gold is disappearing from the streets and going back to the vaults, and that will keep the price supported, and possibly even drive it higher. Until central banks regain confidence in a currency, any currency, gold is not going down."

It was the vision of gold's "disappearing from the streets" that captured my imagination - though I mean this neither positively nor negatively. It is an implication of the current gold bull market that I had not so far contemplated.

For example, we often speak of gold as "an alternative currency." Well, what kind of currency would "disappear from the streets?" It is a mental puzzle... a conundrum... a koan if you will.

But I think manya05 may be onto something? If he or she is right, then gold will continue to function more as a store of value (something for the vaults) rather than as a currency (a publicly-accessible and widely distributed medium of exchange). My instincts tell me that manya05 is likely to be proven correct.

Think about it... if gold moves over the coming years into the thousands of dollars per ounce, as I think it inevitably will, are you going to feel comfortable stuffing a gold coin or bullion bar into your pocket and walking down the street? I don't think so. Gold will be storing too much value per ounce to function as a public unit of exchange.

Far more likely, gold will be consigned to the vault, as well as be subject to rising security concerns. It will remain a store of value, but it will not function as a currency on any broad basis. I certainly don't rule out gold certificates (exchangeable for gold), though even here, I suspect that most gold certificates will be electronic, and subject to electronic security measures, rather than physical.

Hmmm? And what will become of jewellery stores? There will be changes here too, at a minimum, increased security measures in jewellery stores.

I shall leave further speculation on this subject to the fertile minds of my readers. In the interim, here is my own reply (slightly edited) to Mr. Butter's article:

While I find much with which to agree and disagree, I appreciate the general level of intelligence of the commentary at this site. I have read every comment on this article, for example, because I was able to learn by doing so. Few other sites offer much more than rude, emotive or reflexive commentary, so it is refreshing to visit Seeking Alpha (I would appreciate less rudeness, even here, however).

I entered the market in precious metal mining shares when gold was at $330 in 2003 - and wish now that I had been there at $250, whether in 1999 or 2001. I have made a mix of good and bad short-term calls, but my long-term perspective on the gold market has never proven wrong.

The gold price is driven by increases in the money supply, a phenomenon which is pervading every major global currency - including the good ones, such as the Yuan.

I wish it were more complicated than that, but it's not. Monetary inflation (increases in the money supply) is what causes the rising gold price.

That trend has much longer to run, particularly when one considers John Williams' consistently calculated inflation numbers, which place briefly peaking 1980 gold at the $6000 US level. By no indicator of which I am aware is gold anywhere near a bubble, though of course as a contrarian I shouldn't be letting that cat out of the bag!

In fact, every metric and leading indicator that I follow telegraphs that the current gold price breakout is in its infancy.

Does Roubini understand inflation and deflation? I don't think so.
At this time, the big banks (who by the way are the primary shorts in COMEX gold - and thus again wasting taxpayer dollars to bet against the barbaric relic) are playing Fed loans against the treasury market for modest gains on their federally-donated, taxpayer-funded, dollar handouts, rather than taking on additional risk in consumer or commercial loans.

Thus our newly-minted electronic Federal Reserve Notes are not being leveraged into the broader economy - at this point.

It is exactly true that necessities are escalating in price, while discretionary items (let's include the overbuilt real estate market in the latter category) are languishing on the shelves. But that phenomenon is only for here and now.

Our present economy is inflationary, plain and simple. The money supply dam is bursting, and the new dollars will inevitably wend their way through the cracks in the dams of our economic institutions, creating inflation in places that we do and do not expect.

Now, could the entire house of cards collapse in the face of such unprecedented international money printing? I suppose this is still possible. That is, printed Greenspan-Bernanke dollars can be neutralized by being mismanaged, as has already been proven. It's just that the Fed would rather create a new Zimbabwe than see that happen.

As to the correlation of the nominal prices of gold and oil, as I was taught in statistics 101, correlations do not demonstrate cause and effect relationships.

That is, both the gold and oil price are derivative phenomena, of which the primary drivers are (1) the unprecedented increase in the global money supply (pick a currency - any currency), (2) the finite nature of gold and oil supplies, and (3) the utility of both gold and oil.

I have intentionally referred to the utility of gold, as this obvious fact is so often misunderstood in various articles and commentaries.

What is gold good for? It holds one heck of a lot of value in irreproducible form in a very small space. It is a combination of protons, neutrons and electrons that is rare in nature, appealing to the eye, physically dense and compact, industrially useful (just expensive for its most obvious applications), and, above all, historically validated over millennia in diverse human cultures spanning the globe.

That is, currencies have always served as media of exchange, and gold has the most desirable combination of characteristics of any currency on the planet, as has been the case from the dawn of human civilization.

As manya05 stated, "gold is disappearing from the streets and going back to the vaults, and that will keep the price supported, and possibly even drive it higher."

I had not previously meditated on the notion that gold is likely to "disappear" from the streets. Manya05 may have a point here. I'm not sure what will happen to the jewellery stores, but of this I am certain - it is gold in the vaults that is driving the current gold bull market.

I guess perhaps gold could disappear from the streets - and perhaps it will soon enough grow dangerous to carry it visibly on the streets as well (let's not forget what happened to copper pipes in 2007-08!). The demand for gold will be stronger than that for copper, this is certain.

To conclude, is Mr. Roubini wrong to despise gold, at least at this time?

I'd say that at a minimum, he has not yet captured the timing of the gold market. Gold's day is not 3-4 years away. It is today.

Is Mr. Butter correct that gold is "a bubble fuelled by excess valuations?"

At some future point this statement will inevitably prove accurate - yes, the gold bull market will end in a bubble.
But there is not a single indicator that gold is in a bubble today. No, not one.

So as to Mr. Butter's and Mr. Roubini's primary points, both may at some future point be proven correct, but neither has accurately characterized today's gold market (which will continue in a strong rise here and now).

For my other comments on Seeking Alpha, click here.

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